bizzXceleration: Performance, Value and Profit

SPX vs Dollar

Or it could make your head hurt, like it does mine but let's make it worse by circling back to the markets vs dollar question. A while back we took a long look at the impact of exchange rates on the real returns on the stock market using the top part of this chart. It shows the inflation-adjusted vs exchange-rate adjusted SPX and up until 2003 there was no practical divergence. (Now there's a potential investing lesson!). Since then as trade imbalances have grown so has the the divergence and so has the tendency of the dollar to drive the markets inversely. The second sub-chart looks at that directly by comparing the trade-weighted exchange rate for major currencies ($TWX) to the SPX. Pre-bubble there didn't appear to be a lot of relationship but during the bubbles we start to see more...and more with the recent aberrational environment.

From the machinery you'd expect that there'd be a fairly strong relationship between business cycles and exchange rates since during a recovery demand goes up which would increase imports and increase the outflow of $. In the last sub-chart there's some relationship but it doesn't strike us as very clear-cut or stable. So what's going on?

Dollar Driving Factors

Well that's kind of complicated and involves multiple relationships all gyrating together. From the top sub-chart and our trade layer-cake machinery you'd expect one factor would be Net Exports. As NX gets more negative you'd expect the dollar to start dropping. From the top part there's clearly a relationship but it's also another one of those it depends things as well. For example during the '90s the dollar was strengthening while the trade imbalance was getting increasingly worse. Could that have been demand for US equities during the Tech Bubble? Which eventually caught up with us on both fronts (the bubble burst and the imbalances got "too big")? We think that's part of it. And from the middle sub-chart clearly there are business cycle influences, as we noted.

Another major factor though is interest rates. In fact from the bottom sub-chart that seems to be the most clear-cut driving factor, if not the dominant one. As US rates came down and started their long secular decline the dollar followed suit with its own long secular decline, interrupted from time-to-time by other factors, e.g. the Tech Bubble or the recent "Flight to Quality" during the panics last fall. In fact if you look at a shorter-term dollar chart you'll find that after a rapid runup during the flight the dollar is basically returning to that trend. You'll also find that it's flattening out around the 75 level.

Wrapping UP: Long-term Secular Implications

There's a whole bunch of shibbolethic thinking floating around driving Emerging Markets, Dollar depreciation and other asset bubbles. Briefly it's that huge and unaffordable US budget deficits will increase demand for government funding. Now some of that's true and there will be some major impacts. But, paraphrasing Mark Twain, the death of the dollar is greatly exaggerated.

1. A reserve currency must be safe, secure, large and liquid. It's going to be a long time before any other currency can match those requirements and best intermediate term candidate is the Euro. But at the end of the day that will come back to relative growth rates and the long-term prospects of the US are still much better than Europe's, or China's for that matter with the latter's long-term demographic and institutional problems as well as their need to re-structure their economy on a more domestic foundation.

2. As the US saves more it will import less and that will decrease the outflow pressures on the dollar AND increase the domestic pool of funds available for investing in US assets. That means that deficits become more financable domestically for one thing. Coupled to that is the fact that while deficits will be large as the results of previous policy decisions (90% of the deficit problem comes from Bush administration decisions and the financial crisis not new programs) they will not be historically excessive. Again that means that the demand to borrow abroad to finance deficits won't be what people are thinking. A third coupling is that as we demand less and shift to lower energy consumption a similar dynamic sets in with regard to Oil imports.

3. The world needs to re-balance trade flows which requires signifiant adjustments in domestic economies. The US is already making those adjustments and China knows and acknowledges that it needs to but will take time and have political and stability challenges in making them speedily and forcefully.

The bottomlines here are that the US will be a reserve curreny for a long time, though perhaps not the only one and is likely to remain the most important. Another bottomline is that rates will adjust back up since they were abnormally low as the result of the crisis and policy interventions. But we're not likely to see any many surge in rates for a long time and they aren't likely to surge out of control. And, over time, as we get the economy growing again, control deficits and start working them down the doomsayers will find their worries not well-grounded. Which is not to say we aren't facing a decade of slow growth, employment problems and difficulties in writing down the debt. It's what always happens when you've been partying to hard for to long. The hangovers are terrible.

The bottom bottomline is that all the simple answers on investment and business strategy that you've been hearing in the headlines or from the talking heads need to be carefully examined. Will Oil and Commodity demand return to their old levels, speculation included? Unlikely though there are counter-vailing pressures. How about speculating in BRIC equities? Ditto.

More than at any time in a long time this next decade is going to require understanding how things really work from trade to rates to business performance. That's how Warren does it anyway.

 

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READINGS

Dollar up and stocks down–don’t expect that to continue I can’t tell you where stocks are headed in the short term but it does look like the days of the dollar rally are numbered. Why do I think that? The central bank of India tells me so. And if the recent relationship between the U.S. dollar and global equities holds, that means stocks are set to end their current losing streak in the not so distant future. (Recently stocks have gone up when the dollar ha gone down.) The U.S. dollar has an interest rate problem–and it looks like it’s getting worse. The U.S. Federal Reserve has set its target for short-term interest rates near 0%. That makes sense if you’re a central bank desperately trying to get your national economy going. But a 0% interest rate doesn’t help you currency much. Investors can earn more in bonds denominated in Australian dollars or Brazilian reals. Traders can borrow dollars in what’s called the carry trade and then buy assets, again denominated in currencies other than the dollar,  that promise better returns. The desire to sell dollars and hold other currencies gets even stronger when the interest rate differential between the U.S. and other countries is increasing. And that’s exactly what’s happening right now.

Dollar: History, Outlook and Assessments

Growth optimism hits US dollar The dollar hit its lowest level for 14 months on a trade-weighted basis on Thursday as optimism over the prospects for global growth stemmed haven demand. Improving US retail sales figures and a stronger-than-expected fall in weekly jobless claims in the US added to the buoyant sentiment triggered by forecast-beating third-quarter earnings from Alcoa. The dollar index, which tracks its progress against a basket of six leading currencies, fell as much as 1 per cent to a low of 75.767. Late in New York, the dollar was down 0.2 per cent at Y88.45 against the yen and 0.6 per cent lower at SFr1.0262 against the Swiss franc. The dollar also dropped 0.9 per cent to $1.4810 against the euro after comments from Jean Claude Trichet, president of the European Central Bank, weighed on the single currency. At the press conference following the ECB’s policy meeting, at which it kept its main lending rate at 1 per cent, Mr Trichet repeated the mantra that “excessive volatility and disorderly movement in exchange rates” had negative implications for economic and monetary stability.

Dollar Reaches Breaking Point as Banks Shift Reserves Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades. Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase. World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991. The economies of both Japan and Europe depend on exports that get more expensive whenever the greenback slumps. European Central Bank President Jean-Claude Trichet said in Venice on Oct. 8 that U.S. policy makers’ preference for a strong dollar is “extremely important in the present circumstances.”  “Major reserve-currency issuing countries should take into account and balance the implications of their monetary policies for both their own economies and the world economy with a view to upholding stability of international financial markets,” China President Hu Jintao told the Group of 20 leaders in Pittsburgh on Sept. 25, according to an English translation of his prepared remarks. China is America’s largest creditor. “The world is currently flush with the U.S. dollar, which is available at no cost,” Kind said. “If there’s a turnaround in U.S. monetary policy, there will be a change of perception about the dollar as a reserve currency. The diversification has more to do with reduction of concentration risks rather than a dim view of the U.S. or its currency.”  The median forecast in a Bloomberg survey of 54 economists is for the Fed to lift its target rate for overnight loans between banks to 1.25 percent by the end of 2010. The European Central Bank will boost its benchmark a half percentage point to 1.5 percent, a separate poll shows.  America’s economy will grow 2.4 percent in 2010, compared with 0.95 percent in the euro-zone, and 1 percent in Japan, median predictions show. Japan is seen keeping its rate at 0.1 percent through 2010. Central bank diversification is helping push the relative worth of the euro and the yen above what differences in interest rates, cost of living and other data indicate they should be. The euro is 16 percent more expensive than its fair value of $1.22, according to economic models used by Credit Suisse Group AG. Morgan Stanley says the yen is 10 percent overvalued.

Currencies: The diminishing dollar This dollar declinism is overblown. It exaggerates the scale of the slide and misunderstands its cause. Much of the recent weakness simply reverses the earlier safe-haven flight to dollars, a sign of investors’ optimism about riskier assets rather than their fears about America’s currency. On a trade-weighted basis the dollar today is close to where it was before Lehman failed. Yields on Treasuries have not risen and spreads on riskier dollar assets continue to shrink. If investors were growing leerier of dollars, the opposite should have occurred. Furthermore, a weaker dollar is what you would expect, given the relative cyclical weakness of America’s economy. Thanks to the hangover from its financial crisis, America’s recovery will be slower than that of other economies, especially emerging ones. That suggests America’s monetary policy will stay looser for longer, pushing the dollar down. A weaker dollar should also assist global economic rebalancing by helping to reorient America’s economy towards exports. So in general, it should help rather than hinder the global recovery.

• The depreciation of the dollar
• America's public debt
• Why the dollar is drifting downwards

Foreign demand rises for long-term US assets Foreign demand for long-term U.S. financial assets rose in August even though China trimmed its holdings of Treasury securities. Foreigners purchased $28.6 billion more in assets than they sold in August, according to Treasury data released Friday. That followed a net increase of $15.3 billion in July, and $90.2 billion in June. The Treasury Department is auctioning record amounts of debt to cover a deficit estimated to have hit $1.41 trillion for the budget year that ended in September. Some economists worry that if overseas buyers don't keep buying U.S. debt, interest rates could rise. Inflation eats away at the purchasing power of a currency. China trimmed its holdings by $3.4 billion to $797.1 billion in August, but still remained the largest foreign holder of Treasury securities. Japan, the second largest foreign holder, boosted its Treasury securities to $731 billion, from $724.5 billion in July. The federal budget deficit for 2009, which will be officially released later Friday, is expected to more than triple last year's record imbalance. The Congressional Budget Office projects that under President Barack Obama's spending plans, the red ink will total $9.1 trillion over the next decade. The 2009 deficit ballooned as the government spent massive amounts to stabilize the financial system and jump-start the economy. In addition, revenues plunged as millions of Americans lost their jobs and recession-battered companies paid less in corporate income taxes. China's foreign holdings of Treasury securities are a direct result of the huge trade deficits the U.S. runs with China. The Chinese take the dollars Americans pay for Chinese products and invest them in Treasury securities and other dollar-denominated assets.

Wolfgang Munchau: The case for a weaker dollar Imagine a world with a small current account deficit in the US, a somewhat larger deficit in the eurozone and a not too excessive Asian surplus. In such a world, economic commentators would no longer bang on about global imbalances and would have to find a different subject. In the long run, such a world would require significant reform of the international monetary system. In the short term, a fall in the dollar’s exchange rate would help get us there. And I note with some satisfaction that it is happening. A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ. The surplus countries will never adopt policies to get rid of their surpluses. The exchange rate will have to do the job for them. Last week’s announcement of a surprise fall in German exports during August tells me that the hopes of another export-led recovery, as in 2006, are unrealistic. I expect a much reduced current account surplus for Germany in the next few years and, for the eurozone, a sizeable, probably not excessive, current account deficit. The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. Exchange rates cannot solve the problem of global imbalances. They did not in the past. Reform of the global monetary system is necessary for sustained balance. Several proposals are floating around for how this could be achieved, for example the creation of special reserve baskets or the use of the International Monetary Fund’s special drawing rights. I expect we will see neither but are moving towards a dual system in which the dollar and the euro act as the world’s de facto reserve currencies.

Policymakers' strong buck myth stops here Be careful what you wish for. True or false? Policymakers here in the United States tell us that they are in favor of a strong dollar. After all, a muscular buck is in everyone's best interest, so they say. Well, Virginia, if you believe these statements, I have a bridge I would like to sell you. Policymakers are actually happy that the dollar is falling, although they will never admit it. You see, a weak dollar at this point in our business cycle is good for what ails us. And if they thought they could get away with it -- in other words, not trigger a round of competitive devaluations -- policymakers would push the dollar down even further. Now before you accuse me of trying to grow this country by debasing its currency while ignoring the risk that foreign investors might lose faith in our currency and not buy U.S. debt, let me remind you that I don't make the rules, I just play the game. And the game is this: a weak dollar helps exports while curbing imports. Besides reducing our trade deficit, a weak dollar gets people to buy less -- especially from other countries. This has got to be good news for such industries as autos, whose firms have seen many of their customers abandon their products for cars made abroad. It is also tidings of comfort and joy for their many suppliers. More good news comes from the fact that about half of American companies' earnings are generated abroad. The stronger other currencies are, the more dollars they translate into when they are totted up back home. A weak dollar also reduces the need for U.S. firms to outsource, thus costing American jobs. Indeed, if the dollar gets weak enough, some jobs might actually be repatriated. As for the reluctance of foreigners to hold dollars and dollar-denominated instruments, let's face it: Where else are they going to put their money? Weak or not, no other currency rivals the dollar when it comes to safety and ease of moving funds in and out. Another byproduct of a weak dollar, of course, is inflation, as the cost of imports goes up giving some domestic companies cover to raise their tags. If the dollar gets weak enough long enough this could happen. But these are two big "ifs" that are unlikely to occur. You see, trees don't grow to the sky, people don't live forever, and no item's price goes one way indefinitely. Recall the dot-com, tech, stock and housing bubbles, to name some recent examples -- not to mention such oldies as Tulipmania, the South Sea bubble, etc. As they teach in Eco 101, the value of the dollar (or any other currency, for that matter) is determined by supply and demand. Today, world financial markets are swimming in dollars because the Federal Reserve created tons of them to forestall deflation after last year's panic. But lately, the central bank has been making noises about taking some of these dollars back, once it thinks that the economy has regained its sea legs. Does this suggest that the beleaguered buck is more likely to be stronger rather than weaker a year from now? You betcha. As dollars become less plentiful, their value will rise as will foreign investors' willingness to hold them. The threat of inflation will diminish as well. But a stronger dollar will in time reverse all the good things I noted above. It's hard to imagine today, but the dollar could even get too strong -- as happened in the mid 1980s. Remember 1985's Plaza Agreement to drive down the dollar?

The Dollar in Doubt? As I've noted on previous occasions [0] [1], Jeff Frankel and I [pdf] have outlined the conditions under which the dollar could lose primary reserve currency status to the Euro. In short, calamitously bad policies that induce rapid currency depreciation, or high inflation, would do the trick. Our results, last updated in early 2008 [pdf], might seem somewhat out of date given all the turmoil that has occurred in the meantime. But it's important to realize that it's the relative performance (US versus euro area) that matters, and I see no greater reason to believe that the conditions are in place for a drastic "reversal of fortune" than before. So, if one looks at the breathless commentary about the euro's share rising to new highs, well, that's true, insofar as one looks at known euro reserves and known allocations. The picture looks a lot less clear when one tries to think about total reserves, a large share of which is of unknown (well, unreported) composition. As always, a little perspective is helpful. In thinking about the prospects for the dollar, I think it's useful to break the forces affecting it into separate pieces. In particular, reserve currency status is not directly linked to the dollar's value, although they are of course related. The dollar could lose value without losing primary reserve currency status, and could gain reserve share without gaining value. In addition, in thinking about the other forces that can affect the dollar in the absence of tectonic shifts in the dollars international currency role, one can identify a number of factors:

• Portfolio balance effects (dollar asset supply versus demand).
• Cyclical factors (demand for credit, relative price movements, interest rates).
• Safe haven factors
• Structural factors (composition of demand, trend output).

The Dollar Dilemma Legions of pundits have argued that the dollar's status as an international currency has been damaged by the great credit crisis of 2007-9 -- and not a few have argued that the injury may prove fatal. The crisis certainly has not made the United States more attractive as a supplier of high-quality financial assets. It would be no surprise if the dysfunctionality of U.S. financial markets diminished the appetite of central banks for U.S. debt securities. The only problem is that, for all the talk about change, the dollar's importance to the world has not diminished. In the foreign exchange market, the dollar actually strengthened following the outbreak of the crisis. When investors fled to safety, they fled to U.S. Treasury bills. In the face of spreading illiquidity, U.S. and foreign investors alike sought refuge in the most liquid market, the market for U.S. government debt securities. Since then, the dollar exchange rate has fluctuated, but there has been no dollar crash. And there is no evidence of a massive loss of confidence. By process of elimination, it is clear that the dollar will remain the principal form of international reserves well into the future. It will not be as dominant as in the past, for the same reasons that the United States will not be as dominant economically as it once was. In the short run, the euro will gain market share, especially in and around Europe. In the longer run, the renminbi's role will also grow, especially in Asia. But for as far as one can see clearly into the future, the dollar will remain first among equals. This state of affairs -- with several national currencies sharing, albeit unequally, the status of reserve currency -- would not be unprecedented. The emergence of a reserve system based on multiple currencies should not be viewed as alarming. Such an arrangement functioned smoothly before World War I: the different reserve units coexisted peaceably, each in effect with its own constituency.

The rumours of the dollar’s death are much exaggerated It is the season of dollar panic. These panic-mongers are varied: gold bugs, fiscal hawks and many others agree that the dollar, the dominant currency since the first world war, is on its death bed. Hyperinflationary collapse is in store. Does this make sense? No. All the same, the dollar-based global monetary system is defective. It would be good to start building alternative arrangements. We should start with what is not happening. In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar’s fall is a symptom of success, not of failure. Can we find deeper signs that the world is abandoning the US currency? One beloved indicator is the price of gold, which has risen four-fold since the early 2000s (see chart). But its price is a dubious indicator of inflation risks: its previous peak was in January 1980, just before inflation was crushed. Higher prices of gold reflect fear, not fact. This fear is not widely shared. The US government can borrow at 4.2 per cent over 30 years and 3.4 per cent over 10 years. During the crisis, the inflation expectations implied by the gap in yields between conventional and inflation-protected securities collapsed. These have since recovered – yet another sign of policy success. But they are still below where they were before the crisis. The immediate danger, given excess capacity, in the US and the world, is deflation, not inflation. The dollar’s correction is not just natural; it is helpful. It will lower the risk of deflation in the US and facilitate the correction of the global “imbalances” that helped cause the crisis. I agree with a forthcoming article by Fred Bergsten of the Peterson Institute for International Economics that “huge inflows of foreign capital to the US facilitated the over-leveraging and underpricing of risk”.* Even those who are sceptical of this agree that the US needs export-led growth. Finally, what can replace the dollar? Unless and until China removes exchange controls and develops deep and liquid financial markets – probably a generation away – the euro is the dollar’s only serious competitor. At present, 65 per cent of the world’s reserves are in dollars and 25 per cent in euros. Yes, there could be some shift. But it is likely to be slow. The eurozone also has high fiscal deficits and debts. The dollar will exist 30 years from now; the euro’s fate is less certain. This view may be too complacent. The danger of a collapse of the dollar is small and of its replacement by another currency still smaller. But a global monetary system that rests on the currency of a single country is problematic, for both issuer and users. The risks are also growing, particularly since the emergence of “Bretton Woods II” – the practice of managing exchange rates against the dollar.

Dollar hegemony for another century Let me stick my neck out. The dollar will still be the world’s dominant reserve currency in 2030, sharing a degree of leadership in uneasy condominium with the Chinese yuan. It will then regain much of its hegemonic status as the 21st century unfolds. It may indeed end the century even stronger than it was at the start. The aging crisis in Asia — and indeed the outright demographic implosion in Japan and China, not to mention China’s water crisis — will soon be obvious to everybody. Talk of Oriental supremacy will start to sound overblown at first, and then preposterous. Japan is about to go bankrupt. It is on the cusp of a fiscal crisis that will change perceptions of Asia dramatically. The fact that Asian central banks are accumulating $600bn or more a year in reserves by running huge trade surpluses is proof enough that their (mostly rigged) currencies are undervalued by 30pc to 40pc against the West. To that extent, I agree entirely with HSBC currency guru David Bloom that this is untenable. If these countries continue to resist currency appreciation they will overheat and succumb to asset bubbles — if they haven’t already in China. Where I am less sure is that this will necessarily be resolved by a falling dollar. The evidence so far is that Asia will put off the day of adjustment as long as possible because they are addicted to mercantilist export strategies — and export oligarchs control the political systems (bar Japan). In which case they will lose competitive edge the old-fashioned way, by wage inflation for year after year until the world comes back into alignment. If so, the dollar will not fall at all. It may rise. Professor Becker said a collapsing birth rate is extremely hard to reverse, and the cultural effects are insidious. Old societies are status quo. They are slow to embrace new technologies. Young minds are the source of hi-tech invention. The EU is fully aware of the danger. “What is at risk in the medium to long run is nothing less than the sustainability of the society Europe has built and the viability of its civilisation,” said an EU report (initially suppressed) by former Dutch premier Wim Kok as long ago as 2004. Nothing has been done since despite endless warnings from the Commission. China’s work force will peak in absolute terms in six years, and then go into sharp decline. I have no idea how people square this with claims that China will soon replace the US as world hegemon. The stark reality is that China will hit a Japanese-style demographic crunch before it becomes rich. Sheer size will give it weight. But mastery?

Misguided monetary mentalities One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today. What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was what he calls the “gold-standard mentality.” By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an “artificial” recovery. In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.

But we’re past all that now. Or are we? America isn’t about to go back on the gold standard. But a modern version of the gold standard mentality is nonetheless exerting a growing influence on our economic discourse. And this new version of a bad old idea could undermine our chances for full recovery. Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence: the dollar rose at the height of the financial crisis as panicked investors sought safe haven in America, and it’s falling again now that the fear is subsiding. And a lower dollar is good for U.S. exporters, helping us make the transition away from huge trade deficits to a more sustainable international position. What’s even more extraordinary, however, is the idea that raising rates would make sense any time soon. After all, the unemployment rate is a horrifying 9.8 percent and still rising, while inflation is running well below the Fed’s long-term target. This suggests that the Fed should be in no hurry to tighten — in fact, standard policy rules of thumb suggest that interest rates should be left on hold for the next two years or more, or until the unemployment rate has fallen to around 7 percent.

• Modified goldbugism at the WSJ
• Beware the dollar hawks
• The madness of the monetary hawks (wonkish)
• When should the Fed raise rates? (even more wonkish)

Death cometh for the greenback, For the past eight years, the dollar has increasingly become less revered. Its value has been volatile. As the rest of the world saw the United States struggling with a failing war and soaring budget deficits, many who had large dollar holdings began to reduce those reserves (or increase them less than they otherwise would have). All this put downward pressure on the dollar. And thus began the first signs of a vicious circle. The strength of the dollar is becoming riskier and riskier. The growing U.S. deficit and the ballooning of the Federal Reserve’s balance sheets leave many worried that in their wake will come inflation, undermining the long-term attractiveness of the U.S. currency. In this article, I try to explain why the dollar is in trouble, but ask—should we care? What are the consequences? I will suggest that, for the most part, and for most Americans, it is probably a good thing. But the adjustment to a lower value of the dollar will not necessarily come easily. One of the consequences—already under way—is the fraying of the dollar-reserve system. I argue that a move to a global reserve system would be good for the United States, and good for the world. America’s debt-to-GDP ratio is slated to increase from 40.8 percent in 2008 to 70 percent or more by 2019, and if interest rates return to more normal levels of say 5 to 6 percent from their current range of 0.0 to 0.25 percent, it will mean the cost of paying interest on the debt will eat up a substantial fraction of tax revenue (20 percent or more)—unless taxes are raised. The costs of funding programs for the aging baby boomers will only put further strains on the budget. Granted, deficits by themselves need not present a problem. Deficits are of course only one side of a country’s balance sheet. On the other side are assets. If a company borrows money to make high-return investments, no one is worried—so long as those investments do in fact yield returns.Our soaring deficit is not a concern if the money is spent on education, technology, infrastructure—all investments that historically have yielded very high returns, far higher than the interest rate the government has to pay—because then the returns to our society are far greater than the costs. But, if the money is spent on wars in Afghanistan or Iraq, poorly designed bailouts for banks or tax cuts for upper-income Americans, then there will be no asset corresponding to the increased liabilities, and then there is cause for concern. This seems to be the road we have been heading down for the last eight years and, disappointingly, are to too-large an extent continuing to travel. And with it there will be strong incentives to reduce the burden of the debt through inflation because inflation reduces the real value of what is owed. It means the government will pay back its debt with dollars that are worth less than they are today. THE CURRENT system is unstable, leads to a weakened global economy and is unfair. It works to the disadvantage of developing countries, but also to the disadvantage of the United States. It is a system that produces only losers. Developing countries have been putting aside hundreds of billions of dollars in low-yielding reserves instead of undertaking potentially high-yielding investments.

Rates, Monetary Policy and Trade

Treasuries Rise on Speculation Fed Won't Raise Rates Until Late Next Year  Treasuries rose for the first time in three days on speculation the dollar’s decline will spur demand from foreign investors as the Federal Reserve keeps interest rates at a record low through late 2010. Today’s rally follows the biggest weekly decline in Treasuries in two months and comes as the dollar slid to the weakest level against the euro since before the bankruptcy of Lehman Brothers Holdings Inc. Fed Vice Chairman Donald Kohn said very low interest rates will be warranted for “quite some time.”  “A decline in the dollar makes Treasuries cheaper,” said Michael Pond, an interest-rate strategist in New York at Barclays Plc, one of 18 primary dealers that trade with the Fed. “That could encourage some buying. If that trend is expected to continue, then foreign investors should expect a decline in the value of their foreign holdings.”

There Is No Divine Right To A Trade Surplus Another day, another dollar (going down forever.) The reflation trade is on, so on, baby, kick-started by Don Kohn's suggestion last night that the output gap is wider than the Grand Canyon and another wave of better than expected earnings, led by Intel after last night's close. JP Morgan announces at noon London today, kicking off a busy week of kleptocrats' banks' earnings. But while equities are performing strongly, the real story of the day thus far has once again been the dollar. Not only has EUR/USD made a new high for the year above 1.49, but now even oil has broken out, suggesting that a sinking dollar lifts all boats. While the dollar is traditionally weak in Q4 as FX reserve managers top up their non-US$ holdings (a trend that should be in full effect this year as Voldy and co. scoop up zillions in fresh reserves via intervention), it's hard to shake the feeling that the Obama administration is secretly delighted with the demise of the buck. To date, there have been no meaningful adverse effects of a dollar decline- Treasury auctions are still going swimmingly, and oil prices have been in a range for the past several months. Sure, they've had to field the odd angry phone call from the Europeans, but that's pretty small potatoes to date. Still...it's not hard to see a scenario where the Eurogroup (and potentially the ECB) start hammering more forcefully on the Americans about dollar weakness and the Chinese about euro strength. Yet while Macro Man has considerable sympathy for the view that China needs to quit taking the piss when it comes to its and others' currencies, he finds it less easy to swallow the Europeans' viewpoint vis-a-vis the dollar. A few charts will explain why. So what lessons are we to draw from all this? Looking at the assembled charts above, it seems pretty clear that (quelle surprise!) further rebalancing is required in the US. A weaker dollar would appear to be part of that equation; certainly the anecdotal evidence here in the UK (another persistent deficit country with a toilet paper currency) is that sterling weakness has curtailed the amount of foreign-made goods available for purchase. Unfortunately, the (admittedly unscientific) contrast between Japan and Switzerland sends the message that protecting your patch is the right thing to do, while letting the global rebalancing chips fall where they may is an act of supreme folly. It's a message that China and Europe appear to have learned all too well. Looming protectionism has been a flashing dot on Macro Man's radar for sometime; the apotheosis of the DGDF trend is likely to bring it into sharper focus. With the global recovery still on shaky footing, it seems likely that dollar weakness is going to force everyone (including the Americans) to try and protect their patch, whether they "should" be running a positive trade balance or not. Unfortunately, there is no divine right to a trade surplus. Seventeenth and eighteenth century European monarchs once thought that they, too, had a divine right- in their case to rule as they saw fit. That worked fine.....until it didn't. (Just ask Charles I or Louis XVI!!). One can only hope that the denouement to the current "divine right" thinking is a bit less bloody....

Reviewing the recession: Was monetary policy to blame? In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way." There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did: Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium. There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices. Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

Bernanke Calls for Trade-Gap Action Large U.S. trade deficits with developing countries, though smaller than they were two years ago, remain a threat to the global economy, Federal Reserve chief Ben Bernanke said Monday in a speech that called on policy makers in the U.S. and Asia to address the issue. Mr. Bernanke's comments -- in which he urged Asian leaders to build better pension systems and to increase government spending, and the Obama administration to address the U.S. budget deficit -- reflect a growing consensus among world leaders on the need to rebalance global economic growth so it depends less on U.S. consumers. The U.S. shipped dollars overseas to buy foreign-made goods and services. Many emerging-market central banks, wary of letting their currencies appreciate against the dollar and hurting their own export-led growth, recycled those dollars by purchasing U.S. Treasury bonds and other debt. Speaking at a Federal Reserve Bank of San Francisco conference on Asia, Mr. Bernanke said the U.S. financial system was "overwhelmed" by the inflow of capital. "We must avoid ever-increasing and unsustainable imbalances in trade and capital flows," he said.